2019 is shaping up to be a transformative year for Netflix (NASDAQ:NFLX). Coming off its biggest quarter of subscriber additions ever, the streaming service just implemented its biggest price increase ever on domestic subscribers, lifting the monthly charge on most members from $11 to $13.
Meanwhile, the company has been making a play for the Best Picture Oscar, putting together an expensive campaign to make the Alfonso Cuaron-directed drama Roma the winner of Hollywood's most prestigious award, which would be a first for Netflix or any streaming service. Netflix is facing a raft of incoming competition as Disney prepares to launch its streaming service, Disney+, later this year and take over majority control of Hulu with its acquisition of Fox. AT&T, which now owns HBO, Warner Bros. and the Turner Networks, along with Comcast-owned NBCUniversal, and even Apple, are all preparing to launch their own streaming platforms. In other words, 2019 looks to be the year that streaming goes mainstream, with the broadcast and cable giants finally jumping into the fray.
However, Netflix faces a dilemma. Its streaming service is an overwhelming success, now with 139 million paying subscribers, hugely popular both at home and abroad. But Netflix the stock is priced as if the company can grow forever at its current pace forever, valuing the company at a sky-high P/E ratio of 126, which doesn't include its negative-$3 billion in free cash flow last year. While no company can grow forever, in Netflix's case, those limits may be nearer than investors think.
Its U.S., business already appears to be maturing. The company is set to pass 60 million paying households this quarter, hitting the bottom end of its long-term forecast of 60 million to 90 million domestic subscribers. While growth in the international market continues to accelerate, subscriber additions in the U.S. have been steady at 5 million to 6 million in recent years. However, as a percentage, that growth rate is slowing each year even as its content spending increases.
That's one reason Netflix just raised prices on domestic subscribers. It knows viewers won't leave the service, but the company also needs the money to fund its content machine. However, with growth in its domestic subscriber base starting to reach its limit, Netflix needs a new business to justify its valuation and continued stock growth. Sports and other live media present one option, but movie theaters may be the best way for Netflix to extend its brand and tap a new revenue source. I've argued before that Netflix should eventually break into movie theaters, but this year, with competition on the rise and its business maturing, the timing seems better than ever.
The magic of movies
Netflix made its reputation in original programming with TV series. It had early success with House of Cards and Orange Is the New Black, and more recently Stranger Things was a surprise hit. Shows such as The Crown and Unbreakable Kimmy Schmidt have also won acclaim. But recently Netflix has made a concerted effort to buff up its original-movie biz, feeling that it was lacking in the past. After hiring Scott Stuber in March 2017 to head its original film division, production accelerated and those efforts are now bearing fruit. Bird Box, the Sandra Bullock-led thriller, set company records, reaching 45 million viewers on the platform in its first week and an expected 80 million in its first four weeks. Roma scored a Best Picture nomination, Netflix's first, and the company is finally warming up to Hollywood's traditional windowing process, whereby movies are shown exclusively for a period of time before becoming available at home. Roma hit some theaters three weeks before it showed up on Netflix streams, and Bird Box also screened in a handful of theaters first.
In fact, Netflix sounded surprisingly enthusiastic about featuring in theaters, saying in its fourth-quarter report:
We are expanding the film market: while our films drew bigger and bigger audiences in Q4, the North American box office also set records. Today, five weeks after its Netflix debut, ROMA is still being exhibited in theaters and has played on over 900 unique screens around the world, including some special 70mm format presentations. People love films ... at home and in theaters.
In the last line of that quote, especially, Netflix seems to be signaling that it wants more of its films in theaters, as it should. The U.S. box office racked up nearly $12 billion in revenue last year, well ahead of the $7.6 billion Netflix brought in from its domestic streaming subscribers.
Considering Netflix already has a stable of movies that would appeal to theaters, it could easily bump up its bottom line by showing them on the big screen first. If it captured just 1% of the U.S. box office, that would represent an additional $120 million in sales, much of it profit, and the international box office presents another opportunity. Disney, for example, brought in $3 billion in operating profit from its studio entertainment division, on $10 billion in revenue in its last fiscal year, showing the potentially fat margins a movie studio can deliver.
There are two options for Netflix to break into theaters. It can expand the relationships it's already building with theater chains, respecting the traditional windowing process so theaters will be more amenable to the company, allowing greater box office receipts. Or Netflix could go it alone, opening a small set of its own theaters in major cities, where it could cultivate a branded experience in a way similar to what the Apple store does for iPhones and other Apple products.
AMC Entertainment (NYSE:AMC), the world's biggest movie theater chain, has about 11,000 screens and is valued at just $1.5 billion, meaning each screen is valued at less than $150,000. Considering Netflix is spending upwards of $10 billion a year on content, if it could nab, say, 1,000 screens for $150 million, that would seem like a no-brainer. Alternatively, Netflix could try to acquire a small independent chain like Alamo Drafthouse Cinemas.
Netflix is set to produce about 90 movies a year, compared with just 30 each for the major studios, such as Disney, Universal, Warner Bros., Fox, and Paramount, and some of them will have budgets of up to $200 million. That's an enormous output, and pouring billions of dollars into content that only adds marginal valued to its streaming service is clearly leaving money on the table, especially when Netflix knows its service is already so strong that it can easily pass along an 18% price increase barely a year after its last one.
With Disney and AT&T and others ready to enter the mix, Netflix will have to do something new to stay ahead, and the company is already starting to approach a ceiling in U.S. membership. Getting into movie theaters just makes sense, both for the business and for moviegoers.
Jeremy Bowman owns shares of Netflix and Walt Disney. The Motley Fool owns shares of and recommends Apple, Netflix, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Comcast. The Motley Fool has a disclosure policy.